Saturday, December 31, 2016

Remember the promises of the imminent global growth recovery 'next year'? IMF, the leading light of exuberant growth expectations has been at this game for some years now. And every time, turning the calendar resets the fabled 'growth recovery' out another 12 months.

Well, here's a simple view of the extent to which the IMF has missed the boat called Realism and jumped onboard the boat called Hope

Table above posts cumulative 2010-2016 real GDP growth that was forecast by the IMF back in September 2011, against what the Fund now anticipates / estimates as of October 2016. The sea of red marks all the countries for which IMF's forecasts have been wildly on an optimistic side. Green marks the lonely four cases, including tax arbitrage-driven GDPs of Ireland and Luxembourg, where IMF forecasts turned out to be too conservative. German gap is minor in size - in fact, it is not even statistically different from zero. But Maltese one is a bit of an issue. Maltese economy has been growing fast in recent years, prompting the IMF to warn the Government this year that its banking sector is starting to get overexposed to construction sector, and its construction sector is becoming a bit of a bubble, and that all of this is too closely linked to Government spending and investment boom that cannot be sustained. Oh, and then there are inflows of labour from abroad to sustain all of this growth. Remember Ireland ca 2005-2006? Yep, Malta is a slightly milder version.

Notice the large negative gaps: Greece at -21 percentage points, Cyprus at -18 percentage points, Finland at -15 percentage points and so on... the bird-eye's view of the IMF's horrific errors is:

Two 'programme' countries - where the IMF is one of the economic policy 'masters', so at the very least it should have known what was happening on the ground; and

IMF's sheer incomprehension of economic drivers for growth in the case of Finland, which, until the recession hit it, was the darling of IMF's 'competitiveness leaders board'.

Median-average miss is between 4.33 and 4.97 percentage points in cumulative growth undershoot over 7 years, compared to IMF end-of-2011 projections.

So next time the Fund starts issuing 'happiness is just around the corner' updates, and anchoring them to the 'convincing' view of 'competitiveness' and 'structural drivers' stuff, take them with a grain of salt.

Friday, December 30, 2016

Based on the data from FactSet, U.S. corporate performance metrics remain weak.

On the positive side, corporate cash balances were up 7.6% to USD1.54 trillion in 3Q 2016 y/y, for S&P500 (ex-financials) companies. This includes short term investments, as well as cash reserves. Cash balances are now at their highest since the data records started in 2007.

But, there’s been some bad news too:

Top 20 companies now account for 52.5% of the total S&P500 cash holdings, up on 50.8% in 3Q 2015.

Heaviest cash reserves are held by companies that favour off-shore holdings over repatriation of funds into the U.S., like Microsoft (USD136.9 billion, +37.8% y/y), Alphabet (USD83.1 billion, +14.1% y/y), Cisco (USD71 billion, +20.1% y/y), Oracle (USD68.4 billion, +22.3%) and Apple (USD67.2 billion, +61.4%). Per FactSet, “the Information Technology sector maintained the largest cash balance ($672.7 billion) at the end of the third quarter. The sector’s cash total made up 43.6% of the aggregate amount for the index, which was a jump from the 39.3% in Q3 2015”

Despite hefty cash reserves, net debt to EBITDA ratio has reached a new high (see green line in the first chart below), busting records for the sixth consecutive quarter - up 9.9% y/y. Again, per FactSet, “at the end of Q3, net debt to EBITDA for the S&P 500 (Ex-Financials) increased to 1.88.” So growth in debt has once again outpaced growth in cash. “At the end of the third quarter, aggregate debt for the S&P 500 (Ex-Financials) index reached its highest total in at least ten years, at $4.57 trillion. This marked a 7.8% increase from the debt amount in Q3 2015.” which is nothing new, as in the last 12 quarters, growth in debt exceeded growth in cash in all but one quarter (an outlier of 4Q 2013). 3Q 2016 cash to debt ratio for the S&P 500 (Ex-Financials) was 33.7%, on par with 3Q 2015 and 5.2% below the average ratio over the past 12 quarters.

While investment picked up (ex-energy sector), a large share of investment activity remains within the M&As. “The amount of cash spent on assets acquired from acquisitions amounted to $85.7 billion in Q3, which was the fifth largest quarterly total in the past ten years. Looking at mergers and acquisitions for the United States, M&A volume slowed in the third quarter (August - October) compared to the same period a year ago, but deal value rose. The number of transactions fell 7.3% year-over-year to 3078, while the aggregate deal value of these transactions increased 23% to $564.2 billion.”

The above, of course, suggests that quality of the deals being done (at least on valuations side) remains relatively weak: larger deals signal higher risks for acquirers. This is confirmed by data from Bloomberg, which shows that 2016 median Ebitda Multiple for M&A deals of > USD 1 Billion has declined to x12.7 in 2016 from an all-time high in 2015 of x14.3. Still, 2016 multiple is the 5th highest on record. In part, this reduction in risk took place at the very top of M&As distribution, as the number of so-called mega-deals (> USD 10 billion) has fallen to 35 in 2016, compared to 51 in 2015 (all time record). However, 2016 was still the sixth highest mega-deal year in 20 years.

Overall, based on Bloomberg data, 2015 was the fourth highest M&A deals year since 1996.

So in summary:

While cash flow is improving, leading to some positive developments on R&D investment and general capex (ex-energy);

Debt levels are rising and they are rising faster than cash reserves and earnings;

Much of investment continues to flow through M&A pipeline, and the quality of this pipeline is improving only marginally.

There is more evidence of the problem reaching beyond corporate finance side of the markets for debt. In fact, in the U.S. - the economy that led the de-risking and deleveraging efforts during the early stages of the recovery - household debt is now once again reaching danger levels.

Chart 1 below shows that, based on data from NY Federal Reserve through 3Q 2016, full year 2016 average household debt levels are likely to exceed 2005-2007 average by some 3 percent. In 3Q 2016, total average household debt was around USD98,312, a level comparable to USD98,906 in 2006.

And Chart 2 shows that overall, aggregate levels of household debt and per capita levels of household debt both are now in excess of 2005-2007 averages.

Finally, as Chart 3 below indicates, delinquencies rates are also rising, despite historically low interest rates and booming jobs markets. For Student Loans and Car Loans, 3Q 2016 delinquencies rates are 1 percentage points and 3.8 percentage points above the 2005-2007 average delinquency rates. For Mortgages, current delinquency rates are running pretty much at the 2005-2007 average. Only for Credit Cards do delinquency rates at the present trail behind the 2005-2007 average, by some 2 percentage points.

Now, consider the market expectations of 0.75-1 percentage increase in Fed rates in 2017 compared to 3Q 2016 (we are already 0.25 percentage points on the way with the most recent Fed decision). Based on the data from NY Fed, and assuming average 2015-2016 growth rates in credit forward, this will translate into extra household payments on debt servicing of around USD1,085-USD1,465 per annum depending on the passthrough rates from policy rate set by the Fed and the retail rates charged by the banks.

Given the state of the U.S. household finances, this will be some tough burden to shoulder.

So here you have it, folks:1) Corporate debt bubble is at an all-time high2) Government debt bubble is at an all-time high3) Household debt bubble is at an all-time high.Meanwhile, equity funding is slipping even for the usually credit-shy start ups.

And if you want another illustration, here is total global Government debt, based on IMF data:

Wednesday, December 21, 2016

Investment anomalies (or in other words efficacy of exogenous factors in determining abnormal returns to investment) are a matter of puzzle for traditional investment analysis. In basic terms, we normally think about the investment as an undertaking that offers no ‘free lunch’ - if markets are liquid, deep and, once we control for risk factors, taxes and transaction costs, an average investor cannot expect to earn an above-market return. Put differently, there should be no ways to systematically (luck omitting) beat the market.

Anomalies represent the case where some factors do, in fact, generate such abnormal returns. There is a range of classic anomalies, most commonly known ones being Small Firms Outperform, January Effect, Low Book Value, Under-dogs or Discounted Assets or Dogs of the Dow, Reversals, Days of the Week, etc. In fact, there is an entire analytics industry built around markets that does one thing: mine for factors that can give investors a leg up on competition, or finding anomalies.

One recent paper have identified a list of some 314 factors that were found - in the literature - to generate abnormal returns. As noted by John Cochrane: “We thought 100% of the cross-sectional variation in expected returns came from the CAPM, now we think that’s about zero and a zoo of new factors describes the cross section.”

A recent paper published by NBER and authored by Juhani Linnainmaa and Michael Roberts (see link below) effectively tests this Cochrane’s proposition. To do this, the authors “examine cross-sectional anomalies in stock returns using hand-collected accounting data extending back to the start of the 20th century. Specifically, we investigate three potential explanations for these anomalies: unmodeled risk, mispricing, and data-snooping.” In other words, the authors look into three reasons as to why anomalies can exist:

Unmodeled risk reflects the view that some of risk premium paid out in the form of investment returns is not captured by traditional models of risk-return relations;

Mispricing reflects the view that markets’ participants routinely and over long run can misplace risk; and

Data-snooping view implies that anomalies generate returns in the historical data that do not replicate in forward-looking implementation because these anomalies basically arise from ad hoc empirical data mining.

The authors argue that “each of these explanations generate different testable implications across three eras encompassed by our data: (1) pre-sample data existing before the discovery of the anomaly, (2) in-sample data used to identify the anomaly, and (3) post-sample data accumulating after identification of the anomaly.”

In their first set of tests, the authors focus on profitability and investment factors, because prior literature shown that “these factors, in concert with the market and size factors, capture much of the cross-sectional variation in stock returns.”

Finding 1: the authors “find no statistically reliable premiums on the profitability and investment factors in the pre-1963 sample period… Between 1963 and 2014, these factors average” statistically and financially significant returns on average of “30 and 25 basis points per month, respectively.”

Finding 2: “The attenuations of the investment and profitability premiums in the pre-1963 data are representative of most of the other 33 anomalies that we examine. Just eight out of the 36 (investment, profitability, value, and 33 others) earn average returns that are positive and statistically significant at the 5% level in the pre-1963 period.

Finding 3: All of the measures of abnormal returns used in the study generate premiums that “decrease sharply and statistically significantly when we move out of the original study’s sample period by going either backward or forward in time.” In other words, anomalies tend to disappear or weaken every time the authors significantly broaden time horizon beyond that which corresponds to the time horizon used in the original study that uncovered such an anomaly.

As authors note, “these findings are consistent with data-snooping as the anomalies are clearly sensitive to the choice of sample period."

How? "...If the anomalies are a consequence of multidimensional risk that is not accurately accounted for by the empirical model (i.e., unmodeled risk), then we would have expected them to be similar across periods, absent structural breaks in the risks that matter to investors. Similarly, if the anomalies are a consequence of mispricing, then we would have expected them to be larger during the pre-discovery sample period when limits to arbitrage, such as transaction costs, were greater.”

But there is a note of caution due. “Our results do not suggest that all return anomalies are spurious. The average in-sample anomaly earns a CAPM alpha of 32 basis points per month (t-value = 10.87). The average alpha is 13 basis points (t-value = 4.42) per month for the pre-discovery sample and 14 basis points (t-value = 4.06) for the post-discovery sample. Although these estimates lie far below the in-sample numbers, they are highly statistically significant.”

The kicker is that “investors, however, face the uncertainty of not knowing which anomalies are real and which are spurious [or due to data mining], and so they need to treat them with caution. …because data-mining bias affects many facets of returns—averages, volatilities, and correlations—it is best to test asset pricing models out of sample," or absent such opportunity (perhaps due to tight data) - by selecting a model / factor that "is able to explain half of the in-sample alpha".

Full paper: Linnainmaa, Juhani T. and Roberts, Michael R., The History of the Cross Section of Stock Returns (December 2016). NBER Working Paper No. w22894. https://ssrn.com/abstract=2880332

Tuesday, December 20, 2016

One key component of the supply side secular stagnation is the notion that in recent years, corporate investment in the U.S. and other advanced economies have declined on a secular trend (or structurally). With low investment, there is low productivity growth and weak wages growth. The end result is not only lower economic growth, but also declining long term potential growth.

Since the thesis of supply side secular stagnation started making rounds in the economic policy literature, quite a few economists jumped into the debate proposing various explanations to the phenomena. To-date, however, there have not been an empirical study that looked at all reasonably plausible explanations on offer to assess which can account for the decline in capital investment.

German Gutierrez Gallardo and Thomas Philippon, in there paper “Investment-Less Growth: An Empirical Investigation” published this month by NBER do exactly that. The authors “analyze private fixed investment in the U.S. over the past 30 years.”

First, the authors establish that indeed, “investment is weak relative to measures of [firm] profitability and valuation – particularly Tobin’s Q, and that this weakness starts in the early 2000’s.” In other words, whilst firms remain profitable, they simply do not reinvest their profits at the same rate today as in the 1990s.

Per authors, there are “two broad categories of explanations: theories that predict low investment because of low Q, and theories that predict low investment despite high Q.”

As a reminder, Tobin’s Q is a ratio of total market value of the firm to total asset value of asset held by the firm. In simple terms, higher Q means that market value of the firm is higher relative to the cost of replacing the capital and other assets owned by the firm. Thus, a Q between 0 and 1 means that the cost to replace a firm's assets is greater than the value of its stock, so the stock is considered to be undervalued. A Q greater than 1 in contrast implies that a firm's stock is more expensive than the replacement cost of its assets, so the stock is overvalued.

So under the fist argument, if we observe low Q, firms are undervalued by the market and have no incentive to invest as they cannot raise capital for such investment from the markets that perceive the firm’s asset value to be already high (or above the firm value established in the market).

Under the second argument, something other than market valuations drives firm decision to invest or not. What that ‘something other’ is is a matter of various theories.

Some theories postulate that in the presence of financial market imperfections (high costs, low liquidity supply, high risk premiums etc), low investments prevail even when Q is high (market value of the firm >> total assets value).

Other theories, including the one that is currently most favoured as an explanation for dramatic decline in productivity growth in recent years (over the alternative explanation of the ‘secular stagnation’ thesis), the problem is that even with high Q, there might be low investment because there is mis-measurement in the markets as to the value of total assets of the firm. This can happen when there are intangible (hard to value) assets held by the firm, or when assets are dispersed across different currencies, markets and geographic, making them hard to value. It is worth noting that the argument of intangibles is commonly used today to argue that there is no real secular stagnation or decline in productivity growth because “things are simply not measured properly anymore”.

Another view is that decreased competition (either due to technology - e.g. mega aggregators platforms such as google and apple, or due to regulation, or due to trade wars raging on, or broader trend of regionalisation of trade, etc) can reduce investment even in the times of higher Q (high market valuations).

Finally, there is always a view that firms might under-invest because of short-termism in management strategies or due to restrictive investment climate induced by tighter risk governance (the latter point may overlap with regulatory constraints).

The authors find no support for the first argument. In other words, they find that low Q is not causing low investment. No surprise here, as markets are hardly in the mood of attaching low value to firms. In fact, we have been going through a massive uplift in M&As and equity valuations.

Which means that low investment is happening despite high market valuations - we are in the second set of arguments.

The authors “do not find support for theories based on risk premia, financial constraints, or safe asset scarcity”. They also find “only weak support for regulatory constraints.”

“Globalization and intangibles explain some of the trends at the industry level, but their explanatory power is quantitatively limited,” and does not provide support for aggregate - across economy - explanation of low investment.

So here comes the kicker: “we find fairly strong support for the competition and short-termism/governance hypotheses. Industries with less entry and more concentration invest less, even after controlling for current market conditions. Within each industry-year, the investment gap is driven by firms that are owned by quasi-indexers and located in industries with less entry/more concentration. These firms spend a disproportionate amount of free cash flows buying back their shares.”

Let’s sum this up: short-termism is a problem that holds firms from investing more, and it is more pronounced in industries with less competition. Firms which are owned by investors or funds that focus on indexing (pursue investment returns in line with broader indices, e.g. benchmarking to S&P500) invest less. The investment part of secular stagnation thesis, therefore, is linked at least indirectly to financialization of the economies: the greater is the weight of broad markets in investor decision-making, the lower the investment and the shorter is the time horizon, it appears.

Monday, December 19, 2016

Having just reviewed some fresh evidence on the trends and underlying drivers of declining wage growth rates in the U.S. post-Global Financial Crisis (GFC) in the previous post here: , now let’s take a look at some current state of research on income inequality dynamics. In general, relative income dynamics can be driven by increases in income at the top of the income distribution relative to the rest of the distribution - the so-called 1% effect or inequality factor; or by decreases in income distribution at the bottom of distribution - another inequality factor; or they can be driven by the decline in incomes in the middle of income distribution relative to both top earners and bottom earners (polarisation).

A new study from the IMF concerns with the latter type of dynamic. Titled “Income Polarization in the United States” and authored by Ali Alichi, Kory Kantenga, Kory and Juan Solé, study documents “the rise of income polarization - what some have referred to as the 'hollowing out' of the income distribution - in the United States, since the 1970s.”

The key findings are:

“While in the initial decades more middle-income households moved up, rather than down, the income ladder, since the turn of the current century, most of polarization has been towards lower incomes.” In other words, the middle class is increasingly joining the poor, rather than the upper classes.

And this holds for all demographic cohorts or the U.S. population:

CHARTS: Middle-Income Population 1970-2014 (percent of total population with the same characteristic)

So the younger cohorts are now experiencing more hollowing out of the middle class than the older cohorts and this trend started manifesting itself around 2000.

Education no longer protects the middle class, either.

And in racial terms, there is more marked decline in the fortunes of the middle class for the whites, whilst the recovery of the 1990s-2007 period in the fortune of the African-Americans has been reduce by more than 50 percent since the onset of the GFC.

Similarly to race trends, gender trends offer nothing to be proud of.

“…after conditioning on income and household characteristics, the marginal propensity to consume from permanent changes in income has somewhat fallen in recent years.” Put differently, when today’s middle class workers receive a wage increase, they tend to save more and spend less out of that increase than before. This can only occur if today’s middle class workers are saving more from wages increases. Incidentally, the authors also show that the same has taken place for higher income households.

Secular decreases in MPC can reflect either increased investment (from savings) or increased precautionary savings (including savings used to buffer against liquidity risks). Unfortunately, the authors do not look into which effect is at play here, or (if both are) which effect dominates.

And here is another conclusion from the authors worth noting: “Income polarization has risen substantially in the past four decades—much the same, if not even faster than inequality.”

Which, of course, helps explain why we are witnessing activist voting by the disenchanted, angry middle class voters. You can blame political candidates, you can blame the media, you can blame outside forces and powers. But you can't avoid one simple conclusion: the U.S. middle class is pis*ed off with the status quo. For one very good reason that the status quo doesn't work for them.

Full study here: Alichi, Ali and Kantenga, Kory and Solé, Juan A., Income Polarization in the United States (June 2016). IMF Working Paper No. 16/121. https://ssrn.com/abstract=2882555

One of the persistent features of today’s economy is the decline in wage growth and lower returns to human capital, relative to financial capital. Starting with 2010 - the onset of the so-called ‘recovery’ from the Great Recession - annual hourly earnings rose only 2 percent (data through 2015), which is about 1.5 percentage points lower than prior to the Global Financial Crisis (GFC).

This phenomena is not exactly new, but it is becoming increasingly alarming from the point of view of contagion from economic displacement risks to political risks. You don’t need to travel far to spot the issue: just consider the recent U.S. Presidential elections, dominated (apart from dirt flinging between the candidates) by the plight of the disappearing middle class.

A recent paper by Stephan Danninger (IMF), linked below, titled “What's Up with U.S. Wage Growth and Job Mobility?” tries to determine the key reasons for this change in the structure of the U.S. economy.

Danger documents the problem in chart 1 below:

The above chart shows that the decline in wages growth has been pronounced in the face of other labour market dynamics, including the unemployment rate. Which suggests that structural change or structural factors should be more pronounced as the drivers of this trend. This contrasts with previous recessions, when cyclical factors dominate during the early stages of recovery. Per Danninger, evidence points to the fact that following “the deep recession and slow recovery” the U.S. have witnessed “skill erosion and reduced employability of marginal workers. Once labor demand picked up and employment reached workers less attached to the labor market, low entry wages, suppressed average wage growth.”

However, in addition to the above factors, “Davis and Haltiwanger (2014) and Haltiwanger (2015) have pointed to a secular decline in labor market fluidity and business dynamism as possible factors. With productive firms growing less rapidly and the speed of labor reallocation across sectors flagging, technological advances permeate slower through the economy. Labor productivity has been strikingly low in recent years averaging only 0.5 percent during 2013–15 and moves up the wage ladder have become rarer.”

Institutional factors also contribute to anaemic wage growth: “…declines in workers’ bargaining power as a result of less unionization and the emergence of alternative employment arrangements of the “gig” economy (Card and Krueger 2016; Mach and Holmes 2008) have further weighed on average income gains.”

1) “…post-GFC larger declines in local unemployment rates are associated with smaller increases in average wages. …after controlling for the tightness of the local labor market, decreases (increases) in local (county-level) unemployment rates tend to reduce (raise) the average hourly wage rate in the same locality. The preferred interpretation of this effect is a moderating offset of average wage growth through the entry (exit) of low wage earners. This interpretation is consistent with recent findings that the reintegration of workers at the margins of the labor market is holding down median wage rates (Daly and Hobijn 2016).” In other words, when unemployment rises, layoffs predominantly impact those with lower wages (earlier in their careers, part-timers, contract employees, and those with lower productivity), and when unemployment starts to fall, re-hires tend to be of lower average quality than those who managed to stay in employment through the period of higher unemployment.

2) “…structural changes in the labor market are also affecting wage growth”. Which is the main kicker of the paper. Structural changes are those that extend beyond cyclical - recession-linked - factors and as such are long-term trends. Per Danninger, “the wage-growth-Phillips curve has flattened. Declines of unemployment rates …provide a smaller boost to wage growth after the GFC than in the past. …after 2008 wages of full-time full-year employed do not commove with local unemployment rates, while they did prior to the
GFC. …Labor market data up to 2014 no longer show evidence of a similar kink in the post GFC period.”

3) “Job-to-job change rates—associated with higher wage growth—have declined well before the GFC. …post 2000 demographic changes, in particular labor force aging or changes in education, cannot account for the sustained decline in job-to-job transition rates. Rather job-to-job turnover rates have fallen in all education and age groups, irrespective of the tightness of the regional labor market. This common feature is not easily explained by more positive interpretations, such as better job matching or higher return to job tenure (Molly et al 2016).” Traditionally, those who change jobs - job-to-job movers - earn higher wage premia in terms of moving to higher wage growth jobs from lower wage growth jobs. This no longer holds.

As Danninger notes, “these findings have important implications for future wage growth. In the near term, as continued job growth reduces the remaining employment gap — and with it headwinds from the re-employment of low-wage workers—average wage growth is expected to accelerate.”

“However, a return to sustained high wage growth rates is uncertain. The
flattening of the wage-Phillips curve post-GFC points to broader structural changes in the labor market.”

So in summary, including my take on this:

Job-turnover rates have fallen and continue to decline.

“Job-to-job transitions — associated with higher wage growth — have slowed across all skill and age groups”

The above means that the new - post-GFC - labour markets are no longer consistent with ‘normal’ recoveries and that we might be in a structural period of decline in wages growth.

One key structural problem is that of excessive reliance on credit (or debt) to drive growth. We have seen the devastating effects of the rapidly rising unsustainable levels of the real economic debt (debt that combines government obligations, non-financial corporate debt and household debt) in the case of 2008 crises.

And we were supposed to have learned the lesson. Supposed to have, because the entire conversation about structural reforms in banking and capital markets worldwide was framed in the context of deleveraging (reduction of debt levels). This has been the leitmotif of structural policies reforms in Europe, the U.S., in Australia and in China, and elsewhere, including at the level of the EU and the IMF. Supposed to have, because we did not that lesson. Instead of deleveraging, we got re-leveraging of economies - companies, households and governments.

Problem Case Study: U.S. Corporates

Take the U.S. corporate bonds market (that excludes direct loans through private lenders and intermediated loans through banks) - an USD8 trillion-sized elephant. Based on the latest research of the U.S. Treasury Department, non-banking institutions - plain vanilla investment funds, pension funds, mom-and-pop insurance companies, etc are now holding a full 1/4 of U.S. corporates bonds. According to the U.S. Treasury, these expanding holdings of / risk exposures to corporate debt are now "a top threat to stability" of the U.S. financial system. And the warning comes at the time when U.S. corporate debt is at an all-time high as a share of GDP, based on the figures from the Office of Financial Research.

And it gets worse. Since 2007, corporate debt pile in the U.S. rose some 75 percent to USD8.4 trillion, based on data from the Securities Industry and Financial Markets Association - which is more than USD8 trillion estimated by the Treasury. These are long-term debt instruments. Short term debt obligations - money market instruments - add another USD 2.9 trillion and factoring in the rise of the value of the dollar since the Fed meeting this week, closer to USD3 trillion. So the total U.S. corporate debt pile currently stands at around USD 11.3 trillion to USD 11.4 trillion.

Take two:

Debt, after the epic deleveraging of the 2008 crisis, is now at an all-time high; and

Debt held by systemic retail investment institutions (insurance companies, pensions funds, retail investment funds) is at all time high.

Some estimates (see https://www.bloomberg.com/news/articles/2016-12-16/republican-tax-reform-seen-shrinking-u-s-corporate-bond-market) suggest that the Republican party corporate tax reforms (that might remove interest rate tax deductibility for companies) can trigger a 30 percent drop in investment grade bonds valuations in the U.S. - bonds amounting to just under USD 4.9 trillion. The impact would be even more pronounced on other bonds values. Even making the estimate less dramatic and expecting a 25 percent drop across the entire debt market would wipe out some USD 2.85 trillion off the balancesheets of the bonds-holding investors.

As yields rise, and bond prices drop, the aforementioned systemic retail investment institutions will be nursing massive losses on their investment books. If the rush to sell their bond holdings, they will crash the entire market, triggering potentially a worse financial meltdown than the one witnessed in 2008. If they sit on their holdings, they will be pressed to raise capital and their redemptions will be stressed. It's either a rock or a hard place.

Problem Extrapolation: the World

The glut of U.S. corporate debt, however, is just the tip of an iceberg.

And in its Fiscal Monitor for October 2016, the Fund notes that "At 225 percent of world GDP, the global debt of the nonfinancial sector—comprising the general government, households, and nonfinancial firms—is currently at an all-time high. Two-thirds, amounting to about $100 trillion, consists of liabilities of the private sector which, as documented in an extensive literature, can carry great risks when they reach excessive levels." (see http://www.imf.org/external/pubs/ft/fm/2016/02/pdf/fm1602.pdf)

Yes, global real economic debt now stands at around USD152 trillion or 225 percent of world GDP.

Excluding China and the U.S. global debt levels as percentage of GDP are close to 2009 all time peak. Much of the post-Crisis re-leveraging took place on Government's balancehseets, as illustrated below, but the most ominous side of the debt growth equation is that private sector world-wide did not sustain any deleveraging between 2008 and 2015. In fact, Advanced Economies Government debt take up fully replaced private sector debt growth rates contraction. Worse happened in the Emerging Markets:

So all the fabled deleveraging in the economies in the wake of the Global Financial Crisis has been banks-balancesheets deleveraging - Western banks dumping liabilities to be picked up by someone else (vulture funds, investors, other banks, the aforementioned systemic retail investment institutions, etc).

And as IMF analysis shows, only 12 advanced economies have posted declines in total non-financial private debt (real economic debt) as a share of GDP over 2008-2015 period. Alas, in the majority of these, gains in private deleveraging have been more than fully offset by deterioration in government debt:

Crucially, especially for those still believing the austerity-by-cuts narrative presented in popular media, fiscal uplift in debt levels in the Advanced Economies did not take place due to banks-rescues alone. Primary fiscal deficits did most of the debt lifting:

In summary, thus, years of monetarist activism spurring a massive rise in corporate debt, coupled with the utter inability of the states to cut back on public spending and the depth of the Global Financial Crisis and the Great Recession have combined to propel global debt levels past the pre-crisis peak to a new historical high.

Sunday, December 11, 2016

This is a blog about economics and finance, not politics. Alas, geopolitical risks do impact economic risks and they materially influence financial markets. I am trying to stay out of the political analysis and hence offer little in terms of my own thinking on the matter. But that does not mean I should not share with you other analysts' views that I find informative, interesting or thought-provoking. I do so on Twitter, without endorsing (via retweets or 'likes' or shares) any given position, so I shall be able to do the same here, on the blog.

"Is it the 'How' or the 'When' that Matters in Fiscal Adjustments?" asks a recent NBER Working Paper (NBER Working Paper No. w22863). The authors, Alberto Alesina, Gualtiero Azzalini, Carlo A. Favero and Francesco Giavazzi ask a rather interesting and highly non-trivial question.

Much of recent debate about the austerity in the post-GFC world have focused on the timing of fiscal tightening. The argument here goes as follows: the Government should avoid tightening the pursue strings at the time of economic contraction or slowdown. Under this thesis, austerity has been the core cause of the prolonged and deep downturn in the euro area, as compared to to other economies, because austerity in the euro area was brought about during the downturn part of the business cycle.

However, there is an alternative view of the austerity impact. This view looks at the type of austerity policies being deployed. Here, the argument goes that austerity can take two forms: one form - that of reduced Government spending, another form - that of increased taxation.

There is some literature on the analysis of the effects of the two types of austerity compared to each other. But there is no literature, as far as I am aware, that looks at the impact of austerity across different types, while controlling for the timing of austerity policies implementation.

The NBER paper does exactly that. And it uses data from 16 OECD economies covering time period of 1981 through 2014 - allowing for both heterogeneity amongst economic systems and cycles, as well as full accounting of the most recent Great Recession experiences.

The authors "find that the composition of fiscal adjustments is much more important than the state of the cycle in determining their effects on output." So that the 'How' austerity is structured is "much more important" in determining its effects than the 'When' austerity is introduced.

More specifically, "adjustments based upon spending cuts are much less costly than those based upon tax increases regardless of whether they start in a recession or not." This is self explanatory.

But there is an added kicker (emphasis is mine): the overall "results appear not to be systematically explained by different reactions of monetary policy. However, when the domestic central bank can set interest rates -- that is outside of a currency union -- it appears to be able to dampen the recessionary effects of tax-based consolidations implemented during a recession." Now, here is a clear cut evidence of just how disastrous the euro has been for the real economies in Europe during the current crisis. As the authors note, correctly, "European austerity... was mostly tax based and implemented within a currency union". In other words, Europe choose the worst possible type of austerity (tax-based), implemented in the worst possible period (during a recession) and within the worst possible monetary regime (common currency zone).

In allegorical terms, the euro zone was like a food-starved runner starting a marathon by shooting himself in a knee.

The old adage that the road to hell is commonly paved with good intentions, taken through the prism of economic analysis, can often be sharpened by modifying it. In truth, more often then not, the road to hell for some is often paved with good intentions and fortunes of the others.

In the paper, the authors looked at the distribution of gains and losses in the form of air pollution arising from the adoption of electric vehicles in the U.S. To do so, the authors employed "...an econometric model to estimate power plant emissions and an integrated assessment model to value damages in air pollution from both electric and gasoline vehicles." The authors also used the registration location of electric vehicles.

The key findings are:

"...people living in census block groups with median income greater than about $65,000 receive positive environmental benefits from these vehicles while those below this threshold receive negative environmental benefits" For the want of better description, the better off are dumping their pollution onto the less better off via electric vehicles.

"Environmental benefits tend to be larger in states offering purchase subsidies. However, for these states, an increase in subsidy size is associated with a decrease in created environmental benefits." Or put more simply: the greater the subsidies to purchases of the electric vehicles, the lower are the benefits from electric vehicles. Although we have no idea if the associated redistributed costs of these vehicles are any less worse.

The results are pretty intuitive. To power all these Teslas and BMW i-models and the rest of the electric cars lot, one has to generate electricity. Power plants (even those based on renewables, although their social and environmental costs are not factored in the study) are based in areas where those using electric vehicles do not tend to live. So when an executive in Silicon Valley drives her/his Tesla to work, the air pollution around her/him is reduced. But the air around a power generating plant gets worse, because a plant somewhere has to burn some natural gas or captured methane etc to power that Tesla, and that somewhere ain't in the area where the Tesla-driving hipster lives or, even, works.

Hipster's good fortune is a polluting hell for someone who can't afford living outside the industrially intensive areas where hipster's Tesla gets its electricity from. Oh... and one more thing: unlike in normal cases of externalities, there is no mechanism to compensate the losers in this game, because the hipsters get tax subsidies on their Teslas. There is nothing being raised from the beneficiary of the externality to compensate the loser from the externality. Even in theory, someone loses when someone gains.

Thursday, December 8, 2016

More of the same didn't cut it for the American middle class this November, ... and so the Obama voters went to the Republicans, as Hillary Clinton failed to impress onto the middle class any sort of vision they can relate to.

Per Pew Research, out of 57 'solidly middle-class areas' examined, "In 2016, Trump successfully defended all 27 middle-class areas won by Republicans in 2008. In a dramatic shift, however, Hillary Clinton lost in 18 of the 30 middle-class areas won by Democrats in 2008."

So the "deplorables" turned out to be middle-class voters and they clearly heard Hillary Clinton applying a new descriptive term to them. The term they did not quite embrace.

Now, if I were an adviser to the Democratic Party, I would start by putting its leaders in front of a mirror and ask them to point out every little wrinkle and crease in their faces that makes them so publicly loath middle-class as to endorse a candidate that called them 'deplorables'. Step one of the multi-year journey toward rebuilding the party will then be accomplished.

So you know the $13 billion that Apple, allegedly, owes Ireland?.. It really never did owe Ireland much. Instead, it owes the money to taxpayers outside Ireland - in countries where actual business activities took place and in the U.S., where Apple tax avoidance scheme starts, ends and start again. Here's how Bloomberg explains it: https://www.bloomberg.com/graphics/2016-apple-profits/

Oh, yeah, you are reading it right: "a popular corporate tax haven"... that'll be Ireland (per Bloomberg). expect loud protests from Dublin to Bloomberg offices and, potentially, a re-drawing of the scheme to alter the wording...

But you do get an idea: 10 years, at, say $600 million payments, that'll be almost half the $13 billion 'owed to Ireland' that is really U.S. taxpayers cash...

Monday, November 14, 2016

This is an unedited, longer, version of my article for the Sunday Business Post covering my outlook for oil prices.

Traditionally, crude oil acts as a hedge and a safe haven against currencies and bond markets volatility. Not surprisingly, during the upheaval of the U.S. Presidential election this week, when dollar went into a temporary tailspin, equity markets sharply contracted and bonds prices fell, all eyes turned to the risk management staples: gold, oil and, on a more exotic side of trades, Bitcoin. Gold and Bitcoin did not surprise, staunchly resisting markets sell-offs and gaining in value. But oil prices tanked. The old, historically well-established correlation did not apply. Instead of rising, U.S. oil futures fell in the immediate aftermath of Donald Trump’s surprise victory, and then, in line with the stock markets, futures rose. Within the day, U.S. crude futures prices were back at USD45.27 a barrel on the New York Mercantile Exchange, while Brent rose back USD46.36 marker. More broadly, the S&P 500 Energy Sector Index rose 1.5 percent within 12 hours of the election results announcement.

This breakdown in historical patterns of correlations between crude and financial assets prices underlines the simple reality of the continuous oil markets slump: we are in the new normal of systemically low oil valuations underpinned by the very same driving forces that precipitated the crude price collapse from over USD100 per barrel to their mid-to-high 40’s today. These forces are three-fold, comprising reduced demand for energy, reduced demand for oil as a source of energy, and increased supply of oil.

Prices and Stocks
Currently, oil prices are rebounding from the eight-week lows, but prices remain sensitive to any signals of changes in demand and supply. The reason for this is the excess stockpile of oil stored in tankers, ground facilities and at refineries. Most recent U.S. federal data showed oil stockpiles swelling well ahead of the markets expectations, as producers continue to pump oil unabated.

U.S.-held inventories of oil were at 2.43 million barrels at the beginning of November, based on the data from the U.S. Energy Information Administration. American Petroleum Institute puts total stocks of oil in storage and production at 4.4 million barrels - more than 1 million barrels in excess of the seasonally-adjusted forecast for demand. And at the end of October, the U.S. posted a 34-year record in weekly increases in crude and gasoline stocks - at 14.4 million barrels.

The U.S. is no exception to the trend. OPEC recently revised its outlook for oil price recovery for the next three years based on the cartel’s expectation that current levels of production will remain in place for longer than anyone anticipated. Per OPEC latest forecast, we won’t see oil hitting USD60 per barrel until 2020. Only twelve months ago, OPEC forecast for 2020 was USD80 per barrel.

Similar forecasts revisions were produced a month ago by the IMF. In its World Economic Outlook forecast, the IMF revised its outlook for 2016 crude prices from USD50.54 per barrel forecast in October 2015 to USD 42.96 per barrel. 2017 full year price forecast moved from USD55.42 in October 2015 to USD50.64 in October 2016. If in 2015 the IMF was predicting oil prices to hit USD60 marker by mid-2018, today the Fund is projecting oil prices remaining below USD58 per barrel through 2021.

Both, the OPEC and the IMF forecast lower global economic in 2016 and 2017. The IMF outlook is based on world GDP expanding by just 3.08 percent in 2016 and 3.4 percent in 2017, well below post-Crisis average of 3.85 percent and pre-crisis average of 4.94 percent. OPEC forecast for oil prices is based on similarly pessimistic growth outlook for 3.4 percent average growth over the next six years, down from 3.6 percent forecast issued in October 2015.

Alternative Energy: Rising Substitutes
As demand for energy in general remains weak, alternative sources of energy are starting to take a larger bite out of the total energy consumption. Solar power capacity has almost tripled in the U.S. over the last 3 years. Renewables share of the U.S. power supply rose from around 4 percent of total power generation in 2013 to 8 percent this year, on its way to exceed 9 percent in 2017. Solar energy supply is now growing at a rate of almost 40 per annum, spurred on by the Federal solar tax credits, extended by the Congress in early 2016. In Germany, following the Government adoption of Energiewende policies — a strategy that aims to move energy supply away from oil and uranium — renewables now provide almost 30 percent of electricity, on average. And Gwermany’s upper chamber of parliament, the Bundesrat, has passed a resolution calling on the EU to create a system of harmonised taxation and vehicle duties that can ensure that only emission-free cars will be registered in Europe by 2030. On the other side of the spectrum, in the OPEC member states and Russia, renewables energy production is currently standing at below 5 percent of total energy demand. While the number is relatively low, it is rising fast and countries from Saudi Arabia to United Arab Emirates to Russia - all have significant ambitions in terms of lifting non-oil based energy output. In Abu-Dhabi, a recently approved solar energy project will deliver electricity at a cost below coal-fired power plants, at 2.42 US cents per kilowatt-hour, setting world record for the cheapest solar energy supply. Dubai plans to get 25 percent of its energy needs from renewables by 2030. The target is to reach 75 percent by 2050. Even Iran is opening up to use of renewables, with wind and solar investments in 2016-2017 pipeline amounting to close to USD12 billion. In Jordan, just one wind farm - a 38-turbine strong Tafila - is supplying 3 percent of country electricity, since production began in 2015.

All-in, globally, estimated 7 percent of oil demand decline over the last 5 years is accounted for by energy sources substitution. The key drivers for this trend are new environmental agreements, putting more emphasis on alternative energy generation, local environmental pressures (especially in China), and the desire to shift oil production to export markets, away from domestic consumption. Another incentive is to use clean power to reduce domestic subsidies to fossil fuels. According to the IMF report published earlier this year, Middle East, North Africa and Central Asia account for almost one half of the total worldwide energy subsidies. Since the onset of the oil price shock, UAE, Egypt, Oman and Saudi Arabia have been cutting back on fossil fuels subsidies and bringing retail prices for energy closer to market standards.

The second order effect of the above changes in energy composition mix is that moving away from subsidised fossil fuels improves markets transparency and reduces corruption. It also compensates for declines in oil prices in terms of exports earnings.

Drilling at These Prices?

As slower global growth and increasing substitution away from fossil fuels are suppressing demand for oil, supply of the ‘black gold’ is showing no signs of abating. Per latest OPEC statement, oil producers, especially in North America, surprised markets analysts by failing to curb production volumes in response to weak prices. OPEC members have been running production volumes near historical records through out the 3Q 2016. And in the U.S., the Energy Department raised its production forecasts for both 2016 and 2017. However, U.S. crude output this year is unlikely to match the 2015 levels - the highest on record since 1972. All in, the Energy Department now estimates that 2016 average daily production will be around 8.8 million barrel per day (bpd), which is lower than 9.5 million bpd delivered in 2015, but more than forecast for 2016 back in September. Likewise, for 2017, the Energy Department revised its September forecast from 8.57 million bpd to just over 8.7 million bpd in October. Through the second and third quarters of 2016, North American drillers actually increased drilling activity as prices improved relative to late 2015. The number of active oil rigs operating in the U.S. is now up by more than 130 compared to May counts and the rate of new rigs additions is remaining high, rising to 2 percent last week alone.

Russia and Iran
A combination of stagnant or even declining demand, and expanding production means that the only change in the flat trend in oil prices over the next 6-12 months can come only from a policy shock on the supply side. For OPEC, Iran and Russia such a shock is unlikely to happen. Majority of oil exporting economies have either fully (as in the case of Russia and Iran) or partially (as in the case of Saudi Arabia) adjusted their economic policy frameworks to reflect low price of energy environment.

I asked, recently, Konstantin Bochkarev of Forex-BKS, who is one of the leading financial markets analysts working in the Russian markets for a comment on the current state of play in Russian economic policies in relation to oil prices. In his view, “It looks like the worst is over for the Russian economy in terms of adaptations to low oil prices, Western sanctions, geopolitical risks and other challenges of last two years. Sub-50-55 USD oil or even $40 is the new reality and it doesn’t scare any more. On the other hand low efficiency of the economic policy in Russia (due to a lot of constraints like the lack of reforms and the will to change anything before the President election in 2018) means that there’s rather huge cap for the Russian GDP growth which can be limited by 1%-1.5% at 40-55 USD oil.” Overall, “the «crisis policy» which was rather successful during this recession and led to the stabilization of the macroeconomic situations. The recapitalization of the Russian banking system, free float of the Russian ruble, higher interest rates, the transparency of the CBR policy and rather tight budget policy. All these measures finally led to 6% inflation by the end of 2016, rather sufficient decrease in volatility of the Russian ruble and less correlation with oil prices.” And moving away from the petroleum-dominated economy has had even deeper impact. Per Bochkarev, “Oil can’t solve all your problems any more whether it’s 40$ or 100$, because changing social and business environment, external and internal challenges demand something more than budget without deficit or stable cash flow. Still low oil prices can accelerate changes in the Russian economy and society and lead to some necessary reforms or unpopular measures.”

In a sense, Russian experience shows the direction that many oil exporting economies are heading in the age of low oil prices: the direction of accelerated fiscal and monetary responses and gradual structural economic reforms. In some areas, Russia took its medicine first and in a larger dose, but other big producers, including Iran and Saudi Arabia, as well as UAE are also traveling down the same path.

As an aside, it is worth noting that Iranian production is growing ahead of expectations. Per Bloomberg report: “Output at the fields west of the Karoun River, near Iran’s border with Iraq, rose to about 250,000 barrels per day from 65,000 barrels in 2013, the Oil Ministry’s news service Shana reported Sunday, citing President Hassan Rouhani at a ceremony to formally open the project. Iran had expected to reach that output target by the end of the year, Mohsen Ghamsari, director for international affairs at the National Iranian Oil Co., said in September.” (http://www.bloomberg.com/news/articles/2016-11-13/iran-pumps-more-oil-as-saudi-minister-calls-for-opec-output-cuts)

Since the easing of the sanctions, starting with end of January 2016, Iran’s output rose from just around 2.82 million bpd to ca 3.65 million bpd.

Russian producers are also hardly feeling a pinch. According to Bochkarev, “Tax system plays a much more important role in the Russian oil companies production decisions than the rise or fall in oil prices. Whether oil is $40 or $100 per barrel majors are generating generally the same financial results. Besides almost oil majors are stable even at $30 oil. The decreases in oil prices are easily compensated by the fall in the ruble exchange rate. So cost control or cost cutting plays much more important role in other sectors of the Russian economy.”

Still, Russia and Iran might be heading into a direct competition in the European markets, where geopolitics and legacy contracts are changing the playing field away from simple price competition. This new - since January 2016 - competitive dynamic may be a longer term, rather than a current issue, however, according to Bochkarev. “It doesn’t look like that Iranian oil is huge challenge for Russian majors next several years. Numerous consumers who stopped buying the oil from Iran due to sanctions made some changes to their refinery or productions lines and equipment. So Iran has to offer some kind of bonus or lower oil prices to make them return to its oil. Probably it’s much easier for Iran to deal with China, India and other countries in Asia in order to find export markets for its oil. Iran can try to restore market share in Europe but the other hand of such policy can be lower oil prices or necessary discounts. LNG Imports from the US as well as the bigger role of Qatar and Iran in the future are already evident in European markets. The unique status of Gazprom is probably now a matter of the past but the more competitive market can finally make Gazprom more competitive.”

Trump Cards

Which means that economic policies shocks that can alter the current flat growth trend for oil prices are unlikely to come from the OPEC+ countries. Instead, the key to the near-term future variation in oil price trend will most likely come from the U.S. The markets are still assessing the full impact of Mr. Trump’s victory on his foreign and energy policies - the two key areas that are likely to alter the supply side of oil equation, as well as his economic policies that might influence the demand side and inflation. Starting with the latter, if - as promised during the election - the new White House Administration deploys a significant infrastructure and spending stimulus across the U.S. economy, we can expect both the demand for oil to firm up, clearing out some, but not all of the excess supply currently available in the markets. A stimulus to the U.S. growth is also likely to trigger higher inflation. With oil generally being a historical hedge against inflationary pressures, the likely outcome of improved growth performance across the U.S. will be a rise in oil prices from the current range of mid-40s to mid-50s and upper-50s, slightly above the IMF forecasts for 2017 and well ahead of the current market prices.

On the other hand, President-elect has promised to shift Federal supports away from alternative energy toward ‘clean coal’, oil and gas sectors. If he gets his way, the impact will be more American oil flowing to exports and higher excess supply, with lower prices. Mr. Trump’s election is likely to see the Republicans-controlled Congress moving to approve more export-driven pipelines, reducing the cost of oil transport from shale oil rich regions, such as Ohio and Pennsylvania, as well as North Dakota, and increasing incentives to boost production levels. Beyond stimulating production of the U.S. oil, Trump Administration is also likely to green light Keystone XL pipeline that will connect Canadian oil sands to exports terminals in the Gulf of Mexico. This will further expand supply of cheaper oil in the global markets.

Combining the two factors, it appears that the current IMF and OPEC outlook for 2017 for oil prices may be rather optimistic.

Barring a significant surge in global (as opposed to the U.S. alone) growth, and absent supportive cuts to production by the OPEC and other major producing countries, in all likelihood we will see oil prices drifting toward USD52-55 per barrel range toward the second half of 2017. Until then, any significant repricing of oil from USD47-48 per barrel price levels up will be a speculative bet on strong economic growth uptick in the U.S.

Saturday, November 12, 2016

Europe's strong, convincing, systemic recovery ... the meme of the European leaders from Ireland all the way across to the Baltics, and save for Greece, from the Mediterranean to Arctic Ocean comes to test with reality in the latest Pictet Quarterly and if the only chart were all you needed to see why the Continent is drowning in populist politics, here it is:

As Christophe Donay and Frederik Ducrozet explain (emphasis is mine):

"Since 2008, the world’s main central banks have used a vast array of transmission channels: currency weakening to reboot exports; reflation of asset prices to boost confidence; a clean-up of banks’ balance sheets to boost the credit cycle. But, ultimately, all these measures have failed as economic growth remains subdued. Indeed, the belief that countries have become trapped in suboptimal growth and that developed economies, especially in Europe, look set to complete a‘lost decade’ of subpar growth (see graph) since the financial crisis forms the third strand of criticism of monetary policy."

Whatever one can say about the monetary policy, one thing is patently obvious: since the introduction of the Euro, the disaster that is European economy became ever more disastrous.

Enter Trumpist successors to characterless corporatist technocrats... probably, first for worse, and hopefully later, at least, for better...

Thursday, November 10, 2016

Following last night's election results, Bitcoin rose sharply in value, in line with gold, while other digital currencies largely failed to provide a safe haven against the extreme spike in markets volatility.

In a recent project, our students @MIIS have looked at the relative valuation of Bitcoin and Ether (cryptocurrency backing Ethereum blockchain platform) highlighting

Fundamental supply and demand drivers for both currencies; and

Assessing both currencies in terms of their hedging and safe haven properties

The conclusion of the case study was squarely in line with Bitcoin and Ether behaviour observed today: Bitcoin outperforms Ether as both a hedge and a safe haven, and has stronger risk-adjusted returns potential over the next 5 years.

Monday, October 24, 2016

Given a rising prevalence and impact of the cyber attacks in recent weeks, here are some slides from my February 2016 course notes on ERM with warnings about the same back at the end 2015 - start of 2016:

Sunday, October 23, 2016

This is an un-edited version of my latest column for the Village magazine

Since the start of the Global Financial Crisis back in 2008, European and U.S. policymakers and regulators have consistently pointed their fingers at the international banking system as a key source of systemic risks and abuses. Equally consistently, international and domestic regulatory and supervisory authorities have embarked on designing and implementing system-wide responses to the causes of the crisis. What emerged from these efforts can be described as a boom-town explosion of regulatory authorities. Regulatory, supervisory and compliance jobs mushroomed, turning legal and compliance departments into a new Klondike, mining the rich veins of various regulations, frameworks and institutions. All of this activity, the promise held, was being built to address the causes of the recent crisis and create systems that can robustly prevent future financial meltdowns.

At the forefront of these global reforms are the EU and the U.S. These jurisdictions took two distinctly different approaches to beefing up their respective responses to the systemic crises. Yet, the outrun of the reforms is the same, no matter what strategy was selected to structure them.

The U.S. has adopted a reforms path focused on re-structuring of the banks – with 2010 Dodd-Frank Act being the cornerstone of these changes. The capital adequacy rules closely followed the Basel Committee which sets these for the global banking sector. The U.S. regulators have been pushing Basel to create a common "floor" or level of capital a bank cannot go below. Under the U.S. proposals, the “floor” will apply irrespective of its internal risk calculations, reducing banks’ and national regulators’ ability to game the system, while still claiming the banks remain well-capitalised. Beyond that, the U.S. regulatory reforms primarily aimed to strengthen the enforcement arm of the banking supervision regime. Enforcement actions have been coming quick and dense ever since the ‘recovery’ set in in 2010.

Meanwhile, the EU has gone about the business of rebuilding its financial markets in a traditional, European, way. Any reform momentum became an excuse to create more bureaucratese and to engineer ever more elaborate, Byzantine, technocratic schemes in hope that somehow, the uncertainties created by the skewed business models of banks get entangled in a web of paperwork, making the crises if not impossible, at least impenetrable to the ordinary punters. Over the last 8 years, Europe created a truly shocking patchwork of various ‘unions’, directives, authorities and boards – all designed to make the already heavily centralised system of banking regulations even more complex.

The ‘alphabet soup’ of European reforms includes:

the EBU and the CMU (the European Banking and Capital Markets Unions, respectively);

the SSM (the Single Supervisory Mechanism) and the SRM (the Single Resolution Mechanism), under a broader BRRD (Bank Recovery and Resolution Directive) with the DGS (Deposit Guarantee Schemes Directive);

the MIFID/R and the MAD/R (enhanced frameworks for securities markets and to prevent market abuse);

the ESRB (the European Systemic Risk Board);

the SEPA (the Single Euro Payments Area);

the ESA (the European Supervisory Authorities) that includes the EBA (the European Banking Authority);

the MCD (the Mortgage Credit Directive) within a Single European Mortgage Market; the former is also known officially as CARRP and includes introduction of something known as the ESIS;

the Regulation of Financial Benchmarks (such as LIBOR & EURIBOR) under the umbrella of the ESMA (the European Securities and Markets Authority), and more.

The sheer absurdity of the European regulatory epicycles is daunting.

Eight years of solemn promises by bureaucrats and governments on both sides of the Atlantic to end the egregious abuses of risk management, business practices and customer trust in the American and European banking should have produced at least some results when it comes to cutting the flow of banking scandals and mini-crises. Alas, as the recent events illustrate, nothing can be further from the truth than such a hypothesis.

America’s Rotten Apples

In the Land of the Free [from individual responsibility], American bankers are wrecking havoc on customers and investors. The latest instalment in the saga is the largest retail bank in the North America, Wells Fargo.

Last month, the U.S. Consumer Financial Protection Bureau (CFPB) announced a $185 million settlement with the bank. It turns out, the customer-focused Wells Fargo created over two million fake accounts without customers’ knowledge or permission, generating millions in fraudulent fees.

But Wells Fargo is just the tip of an iceberg.

In July 2015, Citibank settled with CFPB over charges it deceptively mis-sold credit products to 2.2 million of its own customers. The settlement was magnitudes greater than that of the Wells Fargo, at $700 million. And in May 2015, Citicorp, the parent company that controls Citibank, pleaded guilty to a felony manipulation of foreign currency markets – a charge brought against it by the Justice Department. Citicorp was accompanied in the plea by another U.S. banking behemoth, JPMorgan Chase. You heard it right: two of the largest U.S. banks are felons.

And there is a third one about to join them. This month, news broke that Morgan Stanley was charged with "dishonest and unethical conduct" in Massachusetts' securities “for urging brokers to sell loans to their clients”.

Based on just a snapshot of the larger cases involving Citi, the bank and its parent company have faced fines and settlements costs in excess of $19 billion between the start of 2002 and the end of 2015. Today, the CFPB has over 29,000 consumer complaints against Citi, and 37,000 complaints against JP Morgan Chase outstanding.

To remind you, Citi was the largest recipient of the U.S. Fed bailout package in the wake of the 2008 Global Financial Crisis, with heavily subsidised loans to the bank totalling $2.7 trillion or roughly 16 percent of the entire bailout programme in the U.S.

But there have been no prosecutions of the Citi, JP Morgan Chase or Wells Fargo executives in the works.

Europe’s Ailing Dinosaurs

The lavishness of the state protection extended to some of the most egregiously abusive banking institutions is matched by another serial abuser of rules of the markets: the Deutsche Bank. Like Citi, the German giant received heaps of cash from the U.S. authorities.

Based on U.S. Government Accountability Office (GAO) data, during the 2008-2010 crisis, Deutsche was provided with $354 billion worth of emergency financial assistance from the U.S. authorities. In contrast, Lehman Brothers got only $183 billion.

Last month, Deutsche entered into the talks with the U.S. Department of Justice over the settlement for mis-selling mortgage backed securities. The original fine was set at $14 billion – a levy that would effectively wipe out capital reserves cushion in Europe’s largest bank. The latest financial markets rumours are putting the final settlement closer to $5.4-6 billion, still close to one third of the bank’s equity value. To put these figures into perspective, Europe’s Single Resolution Board fund, designed to be the last line of defence against taxpayers bailouts, currently holds only $11 billion in reserves.

The Department of Justice demand blew wide open Deutsche troubled operations. In highly simplified terms, the entire business model of the bank resembles a house of cards. Deutsche problems can be divided into 3 categories: legal, capital, and leverage risks.

On legal fronts, the bank has already paid out some $9 billion worth of fines and settlements between 2008 and 2015. At the start of this year, the bank was yet to achieve resolution of the probe into currency markets manipulation with the Department of Justice. Deutsche is also defending itself (along with 16 other financial institutions) in a massive law suit by pension funds and other investors. There are on-going probes in the U.S. and the UK concerning its role in channelling some USD10 billion of potentially illegal Russian money into the West. Department of Justice is also after the bank in relation to the alleged malfeasance in trading in the U.S. Treasury market.

And in April 2016, the German TBTF (Too-Big-To-Fail) goliath settled a series of U.S. lawsuits over allegations it manipulated gold and silver prices. The settlement amount was not disclosed, but manipulations involved tens of billions of dollars.

Courtesy of the numerous global scandals, two years ago, Deutsche was placed on the “enhanced supervision” list by the UK regulators – a list, reserved for banks that have either gone through a systemic failure or are at a risk of such. This list includes no other large banking institution, save for Deutsche. As reported by Reuters, citing the Financial Times, in May this year, UK’s financial regulatory authority stated, as recently as this year, that “Deutsche Bank has "serious" and "systemic" failings in its controls against money laundering, terrorist financing and sanctions”.

As if this was not enough, last month, a group of senior Deutsche ex-employees were charged in Milan “for colluding to falsify the accounts of Italy’s third-biggest bank, Banca Monte dei Paschi di Siena SpA” (BMPS) as reported by Bloomberg. Of course, BMPS is itself in the need of a government bailout, with bank haemorrhaging capital over recent years and nursing a mountain of bad loans. One of the world’s oldest banks, the Italian ‘systemically important’ lender has been teetering on the verge of insolvency since 2008-2009.

All in, at the end of August 2016, Deutsche Bank had some 7,000 law suits to deal with, according to the Financial Times.

Beyond legal problems, Deutsche is sitting on a capital structure that includes billions of notorious CoCos – Contingent Convertible Capital Instruments. These are a hybrid form of capital instruments designed and structured to absorb losses in times of stress by automatically converting into equity. In short, CoCos are bizarre hybrids favoured by European banks, including Irish ‘pillar’ banks, as a dressing for capital buffers. They appease European regulators and, in theory, provide a cushion of protection for depositors. In reality, CoCos hide complex risks and can act as destabilising elements of banks balancesheets.

And Deutsche’s balancesheet is loaded with trillions worth of opaque and hard-to-value derivatives. At of the end of 2015, the bank held estimated EUR1.4 trillion exposure to these instruments in official accounts. A full third of bank’s assets is composed of derivatives and ‘other’ exposures, with ‘other’ serving as a financial euphemism for anything other than blue chip safe investments.

The Financial Undead

Eight years after the blow up of the global financial system we have hundreds of tomes of reforms legislation and rule books thrown onto the crumbling façade of the global banking system. Tens of trillions of dollars in liquidity and lending supports have been pumped into the banks and financial markets. And there are never-ending calls from the Left and the Right of the political spectrum for more Government solutions to the banking problems.

Still, the American and European banking models show little real change brought about by the crisis. Both, the discipline of the banks boards and the strategy pursued by the banks toward rebuilding their profits remain unaltered by the lessons from the crisis. The fireworks of political demagoguery over the need to change the banking to fit the demands of the 21st century roll on. Election after election, candidates compete against each other in promising a regulatory nirvana of de-risked banking. And time after time, as smoke of elections clears away, we witness the same system producing gross neglect for risks, disregard for its customers under the implicit assumption that, if things get shaky again, taxpayers’ cash will come raining on the fires threatening the too-big-to-reform banking giants.

Disclaimer

This blog represents my personal views and is not reflective of the views or opinions held by any company, contractor, client or employer I work for currently or have worked for in the past. These views are not an endorsement to take any action in the markets or of any political position, figures or parties.

“It is not true that people stop pursuing dreams because they grow old, they grow old because they stop pursuing dreams.” Gabriel Garcí­a Márquez

Nassim Nicholas Taleb was asked whether public protests in Athens is a Black Swan Event. He replied: “No. The real Black Swan Event is that people are not rioting against the banks in London and New York.”

"Getting worse more slowly is not the same as getting better", Prof. Brad DeLong